Loss Corporations: Can Their Net Operating Losses Be Preserved for Use in the Best of Times?

As a result of the recent economic crisis, many businesses have generated significant net operating losses (“NOLs”). The potential upside of NOLs is that they are valuable tax attributes which loss corporations may preserve and use to offset taxable income in more prosperous years. Or can they? Be prepared for the potential benefits of and limitations imposed on the use of NOL carryovers in the wake of new legislation and guidance. This article analyzes considerations involving a company’s preservation and use of NOLs. In particular, the article provides in-depth analysis and explanation of the limitation imposed by Congress under IRC § 382, and discusses the government’s NOL legislative measures and IRC § 382 guidance that were issued in response to the economic crisis.

The economic crisis has led to large business losses, an increase in unemployment, a decline in consumer wealth, and a significant decrease in economic activity.  Leading economic observers have claimed that the country is currently in the worst recession and financial crisis since the Great Depression of the 1930’s.[1]  As a result of the unstable economy, many businesses have generated significant net operating losses (“NOLs”).  The potential upside of NOLs is that they are valuable tax attributes which companies may preserve and use to offset taxable income in more prosperous years. Or can they? Realizing the potential for abuse of this attribute, Congress imposed a limitation on the use of NOLs under IRC § 382 to prevent trafficking of such losses.  In response to the economic crisis, however, the White House and Congress passed legislation that provides NOL relief to struggling companies, and the Treasury and the IRS issued guidance that allows investment in or acquisition of troubled businesses without imposing the “IRC § 382 limitation” under certain circumstances.  

IRC Section 382 limits the extent to which a "loss corporation" that experiences an "ownership change" may offset taxable income in any post-change taxable year by pre-change NOLs.[2]  If a loss corporation’s ownership changes by more than 50 percent in value of its stock, then the corporation becomes a “new loss corporation,” and the amount of taxable income in post-change years that pre-change losses can offset is subject to an annual limitation.  The IRC Section 382 limitation determines the amount of income in any post-change year that may be offset by pre-change NOLs and is calculated by multiplying the fair market value of the loss corporation immediately before the ownership change by the long-term tax-exempt interest rate (a published rate of return).[3]  However, a Transferor’s NOL carryforwards are disallowed entirely if the continuity of business test requirements during the two-year period beginning on the change date is not met.[4]   

The economic crisis in 2008 and 2009 spurred the White House and Congress to enact legislation, and the Treasury and the IRS to issue guidance that provides relief for troubled companies adversely affected by the economy.  Legislation was passed that extended NOL carryback periods for “applicable NOLs”[5] and guidance was issued under IRC § 382 concerning the anti-stuffing rule and ownership change provisions that would otherwise subject certain transactions to the IRC § 382 limitation.[6]  

Although the economic crisis has resulted in huge NOLs to many struggling businesses, the NOLs can be valuable tax attributes which companies may preserve and use to shield taxable income in more prosperous years.  Loss corporations, however, must be aware of the potential benefits and limitations imposed on the use of NOL carryovers in the wake of new legislation and guidance...

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[1] “Financial Crisis of 2007–2009” (Last Updated 11/16/09), at http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932009.

[2] IRC § 382(a).

[3] IRC § 382(b)(1).  The Internal Revenue Service publishes a revenue ruling in the Internal Revenue Bulletin each month that contains the long-term tax-exempt rate for ownership changes that occur during that month (that is, the highest of the adjusted federal long-term rates for that month and the prior two months).  See Rev. Rul. 86-133, 1986-2 C.B. 59.